Sunday, January 4, 2009

The Case

US hospitals were overwhelmed today with hundreds of patients suffering from acute heart conditions, their diagnosis - excessive exposure to the cover of this week's edition of the Weekly Standard. Those conservatives who survived the initial shock intact then flooded forums with hysterical comments - Charles Krauthammer gone insane, Kommissar Krauthammer: Oscar Wilde’s Cousin!

Here is the reason with a strong warning: individuals who combine conservative views with poor health are strongly advised to discontinue reading this post.

So here comes a conservative heavyweight, a very influential and respected columnist, arguing for a fuel tax. Should we assume that a countdown to the end of the Middle East is about to start? Unlike Thomas Friedman's somewhat passionate and emotional appeal, this editorial features a dry and technical style, a hallmark of Krauthammer's editorials. This is a 100% technical stuff. Krauthammer first explains the reasons and then goes into details of a possible tax swap and he lays out very clear conditions on which the conservative hardcore wants it to be done.

Here is how it works. The simultaneous enactment of two measures: A $1 increase in the federal gasoline tax--together with an immediate $14 a week reduction of the FICA tax. Indeed, that reduction in payroll tax should go into effect the preceding week, so that the upside of the swap (the cash from the payroll tax rebate) is in hand even before the downside (the tax) kicks in.

The math is simple. The average American buys roughly 14 gallons of gasoline a week. The $1 gas tax takes $14 out of his pocket. The reduction in payroll tax puts it right back. The average driver comes out even, and the government makes nothing on the transaction. (There are, of course, more drivers than workers--203 million vs. 163 million. The 10 million unemployed would receive the extra $14 in their unemployment insurance checks. And the elderly who drive--there are 30 million licensed drivers over 65--would receive it with their Social Security payments.)

. . .

Of course, as with any simple proposal, there are complications. Doesn't reimbursement-by-payroll-tax-cut just cancel out the incentive to drive less and shift to fuel-efficient cars? No. The $14 in cash can be spent on anything. You can blow it all on gas by driving your usual number of miles, or you can drive a bit less and actually have money in your pocket for something else. There's no particular reason why the individual consumer would want to plow it all back into a commodity that is now $1 more expensive. When something becomes more expensive, less of it is bought.

The idea that the demand for gasoline is inelastic is a myth. A 2007 study done at the University of California, Davis, shows that during the oil shocks of the late 1970s, a 20 percent increase in oil prices produced a 6 percent drop in per capita gas consumption. During the first half of this decade, demand proved more resistant to change--until the dramatic increases of the last two years. Between November 2007 and October 2008, the United States experienced the largest continual decline in driving history (100 billion miles). Last August, shortly after pump prices peaked at $4.11 per gallon, the year-on-year decrease in driving reached 5.6 percent--the largest ever year-to-year decline recorded in a single month, reported the Department of Transportation. (Records go back to 1942.) At the same time, mass transit--buses, subways, and light rail--has seen record increases in ridership. Amtrak reported more riders and revenue in fiscal 2008 than ever in its 37-year history.

Gasoline demand can be stubbornly inelastic, but only up to a point. In this last run-up, the point of free fall appeared to be around $4. If it turns out that at the current world price of $39 a barrel, a $1 tax does not discourage demand enough to keep the price down, we simply increase the tax. The beauty of the gas tax is that we--and not OPEC--do the adjusting. And that increase in price doesn't go into the pocket of various foreign thugs and unfriendlies, but back into the pocket of the American consumer.

Technical to the extreme but Krauthammer does convey a sense of urgency:

We underestimate our power. Of course, the slump in China and other rapidly growing economies has contributed to the current extreme price collapse. But China consumes only 9 percent of the world's oil. The United States consumes 24 percent. On the other hand, Saudi Arabia produces 13 percent of the world's oil. We don't generally see ourselves as the Saudi Arabia of oil consumers, but we are. The Saudis have the most effect on the world price because they are the swing producer. We are, in effect, the swing consumer. And since oil peaked earlier this year, we are consuming less. October was yet another month of record year-on-year decline of gasoline consumption in the United States. And that's just the immediate effect, before the long-term impact of changes in our automobile fleet can take hold. And that long-term change will only occur if we keep the domestic price high.

. . .In our current economic crisis, there is but a single silver lining--the collapse of world oil prices. This in turn is already stimulating a struggling economy, helping our balance of payments, humbling OPEC, and weakening our adversaries. When economic conditions improve, and oil consumption and prices rise again, these benefits will evaporate precisely as they have time and again since the first oil shock of 1973. A time of $1.65 gasoline is our chance to enact a net-zero gas tax. It is a once in a generation opportunity that we cannot afford to miss.

Yes, a high gas tax constitutes a very serious government intervention. But it has the virtue of simplicity. It is clean, adaptable, and easy to administer. Admittedly, it takes a massive external force to alter behavior and tastes. But given the national security and the economic need for more fuel efficiency, and given the leverage that environmental considerations will have on the incoming Democratic administration and Democratic Congress, that change in behavior and taste will occur one way or the other. Better a gas tax that activates free market mechanisms rather than regulation that causes cascading market distortions.

One thing that stands out about the US free market conservatives is this. In the American political culture tax cuts are equivalent to European welfare states, minimum wages and social spending. America seems to be generally very low on social capital which is usually high in smaller and more homogeneous societies such as Sweden was until a decade or something ago. In fact, America is probably just too big and its sheer size requires quite an effort from that part of the human brain that's responsible for forming national identities. That's why beyond the passionate flag waving, the sense of social solidarity is actually not very high and people are generally reluctant to pay taxes. Given that low taxes and minimal state intervention constitute an important part of the free market doctrine, there has been produced a strange phenomenon of tax cuts not as part of austerity measures or structural reforms but as regular political commodities traded by deeply populist and economically ignorant politicians to a no less economically ignorant and extremely receptive to populist rhetoric electorate, all this, nevertheless, accompanied by a no less populist and void of substance pseudo free market blah blah blah.

This trait of the American political culture has two major effects. First, the US has become culturally and ideologically predisposed to getting up to its neck in out of control deficits and debts since many of these tax cuts are severely deficient not only in the economic but just plain human common sense. It should be also mentioned that the conservative idea of free market is not very economical from the beginning and it just can't be other way given the total lack of any economic thinking in the overwhelming majority of the conservatives. The conservative view of free market is just a part of a much bigger ideal of a self governing society where the government is nowhere around and the society is sustained by the self interest or voluntarism of its citizenry. This utopia in some respects resembles the ideal society dreamed in Russian and other Communisms, even though in the Communist case the exact opposite had been achieved. As they say, extremes meet.

As a matter of fact, extremes have met in the case of America just as well and this is the second consequence of this "free market" approach to taxes. Since without taxes, by far the most market friendly tools for carrying out economic policies, the regulators were left with the most socialist methods for achieving their goals of energy independence and universal home ownership. For example, the measures undertaken or considered for the sake of energy independence include everything from ethanol subsidies and mandatory blends to this crown jewel of the American free market approach to energy policy which is hardening of energy efficiency standards. Some of these, even taken in isolation, can put to shame Scandinavian socialist paradises. All of them, however, can be easily replaced by a single gas tax.

Of course, the ethanol subsidies, tax breaks for national oil companies and their friends have all their price. But a combination of economic ignorance and unshakable belief that the world is teeming with opportunities for getting free lunches led the American public to believe that it's paying nothing for having these. Very illustrative in this sense are the tax cuts carried out by the Bush administration which were basically defunding the state at a time when people and businesses were all busy leveraging themselves up. It's important to see this in a wider context of what was happening in the American society as a whole. In times of crises Wall Street usually takes the brunt of fingering, but it's important to see that the whole of America was one big Wall Street, the society stopped saving and went on a consuming binge fueled by a runaway abuse of mortgages and credit cards. The US government with its mounting deficits and debts was a reflection of a nationwide trend that has very little to do with free markets as such. Any person, even with the most minimal pro market orientation, would be wasting his time searching here for any signs of budget and fiscal discipline that we came to associate with free market economic policies, since there are none.

By the end of the Bush presidency a significant portion of the conservative camp has degenerated into a bunch of political kamikazes in the sense of them refusing to have any policy whatsoever. Anybody who has happened to visit conservative blogs could not fail to get amazed by the sheer amount of articles disproving the global warming recycled there. The same can be easily observed now on the same blogs with regards to Krauthammer's call for a fuel tax. Some conservatives have joined forces with the greens to oust the ethanol program, others for the sake of consistency are also calling for repelling the tax breaks for oil companies (American oil is not cheap. Without an import duty on foreign oil, withdrawing these tax breaks is bound to lead to closure of fields and increased imports of foreign oil).

The conservatives were simply refusing to deal with any of the three major challenges facing their country: energy crisis, radical Islam and global warming. In this sense it can be said that by the time Obama has won the elections, the conservatives had pretty much nothing to offer to their bankrupt nation beyond more tax cuts and invading a couple of more countries in the Middle East. It is not that Obama has something sensible to offer instead, but at least he is trying.

January 9, 2009

24 > 13

We underestimate our power. Of course, the slump in China and other rapidly growing economies has contributed to the current extreme price collapse. But China consumes only 9 percent of the world's oil. The United States consumes 24 percent. On the other hand, Saudi Arabia produces 13 percent of the world's oil. We don't generally see ourselves as the Saudi Arabia of oil consumers, but we are.

The US almost twice as much a swing consumer of oil as the Saudis are a swing producer - 24 percent of the market vs 13 percent, of course it's still much easier for the Saudis to cut supplies than for the US to control its demand. However, this also means that to counteract a 10% decline in demand in the US the Saudis have to cut twice as much in supplies. OPEC has never excelled in self discipline of its members and the implicit Saudi threat to open the floodgates and flood the market with cheap Saudi oil is as much responsible for OPEC's existence as the self interest of its other members. In fact, OPEC controls only a section of the global oil supplies, about 1/3. There are enough producers in the world all too eager to take advantage of OPEC's production cuts. This makes the organization's control of the market a limited one. In fact, it can be said that OPEC's control is determined very much by a degree to which the US is willing to cede this control to external producers. There is very little OPEC can do against a deliberate effort on the part of the US to cool down its appetite for carbon fuels.

As I've already explained here a tax swap (introduction of a gas tax in exchange for equal cutting in payroll or some other taxes) amounts to cutting taxes. Those unconvinced can read this. However the US being a swing consumer introduces an additional dimension to such a tax swap since any significant reduction of the US demand for oil is prone to sending the prices tumbling down so the taxpayers are likely to benefit twice from such a tax swap. First, because a gas tax can be avoided by taking very simple measures such as driving less as well as by long term strategies such as switching to hybrids or using increased ethanol blends. But as they are doing this, the consumers are shrinking the demand for oil increasing the pressure on the price to fall. And so here they are creating another opportunity for themselves to benefit from a tax swap, this time because a tax swap is bound to exercise a downward pressure on the price of oil.

Here it should be very apt to point out to a big difference between trying to replace carbon fuels with cheaper alternatives such as subsidized ethanol and pushing oil out of the market by pricing it out using fuel taxes. Technically speaking and contrary to the idea many people have of the matter, there are no two separate markets - one for oil and another for alternative energies. There is basically only one market - the energy market. In this sense it's pretty much irrelevant what part of this market is getting subsidies or tax breaks, you end up inflating the market as a whole. As long as oil producers can lower their prices in line with the advance of alternative energies, the price of energy is going down expanding the demand. The US has an insatiable appetite for energy and seems capable of taking in as much oil and other energy as is available. This is really only a matter of price. In this sense, it's not clear how much oil the American ethanol program based on subsidies has succeeded to displace at all. It may well be the case that most of this ethanol has rather added itself to the market instead of actually reducing the consumption of carbon fuels. Such an energy policy is always at risk of turning into another story of a dog who was chasing its own tail.

The situation becomes rather different if instead of subsidies the regulators go on pricing oil out through a series of tax swaps. This would create an opening for ethanol and other alternative energies not by making them cheaper, but by making oil more expensive. Under such conditions even without cheaper alternatives, the demand for oil will be shrinking just because of increased energy conservation. Energy conservation can come in many forms such as less and more prudent driving, driving people and businesses closer to each other (less suburban sprawl for example) and such stuff. If on top of this ethanol and others move in, they will have a very concentrated and powerful impact on the market. Every drop of such an unsubsidized ethanol will replace a drop of oil. An ethanol program implemented along these lines may create a total meltdown on energy markets outside the US where Russians, Arabs and others are selling their oil.

In fact, all calculations done until now on how much oil cellulosic and non cellulosic ethanol can displace, and a possible environmental impact of this program on land and water, would be very different if the regulators switch to tax swaps as a primary instrument of their energy policy. Basically biofuels should account for something between 1/4 to 1/3 of the auto fuel market in the US by 2020 and without imports not much more can be achieved in terms of ethanol due to land constraints. However, a gas tax is bound to significantly shrink the overall demand for carbon fuels, or at least keep the demand at bay, and the same amount of ethanol may easily suffice to replace as much as 50-60% of the market. Add to this agricultural subsidies paid to cotton producers and others that can be used to encourage these producers to move to biofuels and the future of oil in the US becomes uncertain.

Of course, the surest way to achieve energy independence, or better independence from oil, would have been for the US to impose a gas tax and open its market for Latin American ethanol. This year for the first time ethanol was outselling gasoline in Brazil and this is despite collapsing oil prices. Brazil has become a leading ethanol exporter, a major world producer second only to the US and not by a wide margin, while its sugar cane plantations supplying local ethanol producers barely account for 1% of the country's arable land. Brazil can easily double and triple its ethanol production and it's by far not the only nation capable of supplying the US market with cheap Latin American ethanol. However, the ethanol program was crafted in such a way that does not allow the US to take advantage of ethanol produced outside the US. And with such a powerful lobby behind the local corn ethanol and Obama about to take office, the chances of a sensible policy change regarding ethanol imports are more remote than ever.

Some people may argue that what I am posting here sounds too good to be true. For these I have the following to say. In the wake of the current crisis many people have been asking themselves how such a crisis could have happened at all. How it's possible that the world's only superpower hosting the best MBA's schools in the world could have produced such a huge amount of economic and business fallacies. The gas tax and its implementation, or better non implementation, is basically the other side of the same story. The only difference between the tax and the crisis is that the crisis has already happened while the gas tax may not happen at all, but in all other respects it's a failure of the same proportions and its causes are the same. Those who find my interpretation of the gas tax too good to comprehend how the tax was allowed to not happen, should ask themselves if the current crisis is not just as bad to comprehend how it was allowed to happen.